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Testing times

 

by Heike Dieckmann
While fear of the dreaded recession in the US is no doubt taking hold among many OP industry players, nobody – especially in Europe – appears to be pressing the panic button just yet. The trick, some say, is to convert survival tactics into opportunities.
Everybody’s talking about it – the economy, the looming recession in the US and how both are going to impact everybody’s life in the near to medium term. Analysis from economists and investors spells more than just a little gloom and reaches far beyond the borders of the US.
Reports issued by the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) in late April, for example, warned that the United States is entering into a recession, with both organisations rejecting claims that Europe will be able to avoid severe economic dislocations as a result of the country’s worsening situation.
The IMF predicts that the US will go into a "mild recession" this year, with growth of around 0.5 percent. It warns that there is a one-in-four chance of a full-blown global recession over the next 12 months. At best, it forecasts that world economic growth will fall to 3.7 percent in the next two years.
Are the effects of these bad news stories already rippling through the office products industry and, if so, are they felt primarily domestically or also globally?
Cost issues
Starting with the sub-prime mortgage crisis, the key impact from this on our industry is capital availability and cost. And while the housing market (and home-building) and the financial sectors are facing problems that are easily identified and quantified, the issue of cost ultimately impacts all goods and services – office products included.
For now, the feeling of gloom appears to be most prevalent in the US. A host of OP companies – from manufacturers over wholesalers to the OP superstore and contract giants – have at least partially blamed the state of the economy for their woeful financial results.
• OfficeMax blamed the weaker economy for lower sales performance in both its retail and contract segment.
• Office Depot continued to blame the US housing market slump as its Q1 earnings fell by 55 percent compared to 2007.
• Newell Rubbermaid lowered its full-year earnings estimate and said that "significant increases" in raw material costs and sourced products were to blame for the revised forecast.
• Avery Dennison reported lower Q1 earnings as a result of weak US demand and higher raw material costs, and lowered its outlook for the year.
• SP Richards reported a 2 percent fall in its Q1 sales to $442.4 million, while operating profit dropped by almost 9 percent to $43.9 million. Much of this was due to "sluggishness" in the OP industry, the company said.
• United Stationers’ Q1 sales were down about 1 percent to $1.18 billion which the company blamed on the weak economy and the timing of the Easter holidays in March. While sales in the janitorial and breakroom category were up 15 percent, product segments such as office supplies, technology products, and office furniture combined were down approximately 5 percent.
Dave Guernsey, CEO of Virginia-based Guernsey Office Products, sums up the situation from an independent dealer perspective, a channel not bound by quarterly shareholder expectations. He says: "The economy in our trading markets has been up and down throughout our current fiscal year. Some months have been very good and others pretty far off our normal performance. For our financial year to date [starting July 2007], we’re running at just over 99 percent of our plan.
"My peers report similar experiences in their parts of the country. Some areas – especially where job growth is flat or negative – are generally down, but are also reporting the same up and down demand we’ve experienced. We are all seeing – as is typical in a downturn – furniture sales taking the biggest hit [see also ‘Office furniture: Feeling the pinch’]. Consumers are no doubt very cautious as they try to figure out what has happened and what is going to happen."
As United’s results show and Guernsey points out, impact on sales depends hugely on product categories as well as – to a lesser extent – demographics. Discretionary spending is the first to be knocked back, and this applies especially to office equipment, furniture or even desk accessories where people have a choice not to buy.
On the other hand, and certainly on the B2B side of the business, companies always need ink, toner, pens and paper. Consumables especially have become a huge percentage of overall spend and those products are likely to see the smallest impact on sales.
Margin pressure
They are also the categories with the lowest margins. As such, margins remain and are likely to come under even more pressure as higher margin products typically fall under the discretionary spending umbrella.
Price increases can be the answer – especially at a time when raw material and energy costs are on a steady upward trend – and they definitely help top line performance. That said, implementing price rises in a climate of weak demand is a real challenge.
So what to do in a downturn such as the current one in the US? Says Guernsey: "In any downturn we ratchet up our zero-based budgeting approach and scrutinise every expenditure in even greater detail. We don’t want to take anything away that beneficially touches the customer, but every item is reviewed, re-justified and adjusted in terms of short-term as opposed to long-term value. As far as compromising the future is concerned, we feel the best way to sustain the value we offer is to maintain a strong balance sheet by continuing to achieve reasonable returns on invested capital. Top line does not trump bottom line.
"Overheads aside, Guernsey asks more of its sales and customer support staff – work harder, dig deeper, manage existing customer accounts ever more closely. Downturns also offer opportunities and not every competitor rises to the occasion. We certainly don’t want to be one that checked out of the market because activity was not to our liking."
Fighting talk indeed, mirrored across the Atlantic by Eric Bigeard who, by and large regards the impact of the economy on Lyreco as negligible and doesn’t expect that to change anytime soon. "We’re very prudent and we watch the trends carefully. The US has been impacted now for some time, but I don’t believe we will see that kind of trend in Europe, not at Lyreco and not in the general European economy either."
US influence on UK
The UK is regarded as the European country most exposed to the economic turmoil unleashed in the US and the one most heavily dependent on world financial markets. But here again, Bigeard is confident. He says: "Lyreco is still growing in the UK and it’s growing faster than the market. That’s primarily due to some strong sales performances in the large account segments, so we don’t perceive any impact directly in the UK from the economy."
Rob Vale, CEO at UK-based Spicers, is not so optimistic as far as his home market is concerned: "We’re led to believe that the credit crunch is over, but I’m not entirely sure about this. We keep hearing that house prices are expected to fall between 5 and 10 percent over the next year.
"The fact is that the UK economy has been riding on the back of rising house prices for some time. Of course it’s not the only influence on the economy, but it’s a big contributory factor and if the wheels fall off, then people will rein in how much money they spend – office products included. And we’re definitely seeing that already, not just in our business, but in the general retail market. There’s real angst out there about what’s happening."
The picture in some of Spicers’ and Lyreco’s continental European markets looks somewhat different and – with the exception of Spain which recently reported its slowest quarterly pace of growth for 13 years and has been hit hard by tumbling house prices – altogether more positive.
Germany in particular seems to defy the global economic storms at the moment with GDP growth of 1.5 percent in the first quarter of this year, the fastest quarterly rate for almost 12 years, according to the country’s statistical office. Its exports also continue to rise, even though the euro has dramatically risen in relation to the dollar. In addition, consumer spending – considered the country’s Achilles heel – also appears to have been helped by falling unemployment.
Both Spicers and Lyreco are reporting solid growth in Europe’s economic powerhouse and are similarly confident about the French market which has also reported growth.
Inflationary pressure
All that good news aside, while countries like the US and Japan are most concerned about slowing economic growth, in many regions, including Europe, parts of Asia and South America, it’s inflation that is becoming a major problem.
In Europe, for example, inflation is now running at a record 3.6 percent in the euro zone. The European Central Bank has set its main policy interest rate at 4 percent, but fears that inflation will make this unsustainable. Food and energy price rises alone added 1.6 percentage points to March’s inflation figures. Asia, including Malaysia and Singapore, are also affected, with China battling with its very own set of challenges and just one of them being inflation (see also box, ‘China – a deflating balloon?’).
Vale believes that the inevitable outcome of the current situation and the inflationary tendencies are price increases in office products categories. He says: "We’re going to see inflation in office products in the middle of this year, there’s no doubt about it. There’s a whole bunch of price rises on the way. You might say that’s counter-intuitive given what’s happening in the economy, but with raw material and energy prices as well as transport costs going up and up and up, that’s going to hit. So you’re going to have a tough economy at the same time you’re battling with rising prices."
There are no hard and fast rules about how to proceed, but according to Guernsey, the trick is "not just surviving a bad economy but, more importantly, doing so in a way that you can optimise opportunities as the curve turns back up. It’s not enough to just take a deep breath and hang on…"
Office furniture: Feeling the pinch?
Often regarded as a barometer of what’s going on in the economy as a whole and even reflecting the profitability of the world’s largest corporations, the office furniture sector represents a high level of capital expenditure in the overall OP industry.
And in the US, the slowdown in spending and the aftermath of the credit crunch is beginning to bite. The Business and Institutional Furniture Manufacturer’s Association (BIFMA) predicts flat production rates of US office furniture manufacturers this year at $11.4 billion, the same figure as 2007, while the forecast for 2009 sees a downward trend of 2.6 percent to $11.1 billion.
According to an online opinion poll conducted by the Monday Morning Quarterback (MMQB.com) among office furniture manufacturers as well as resellers, 67.8 percent of respondents fear that the downturn in the furniture industry will last more than a year (as opposed to 22.5 percent who said it will last between three and nine months, for instance).
But while the sector is clearly affected, resellers remain reluctant to use the ‘recession’ word, instead preferring to call it a slowdown, according to Chris Bates, president of the US-based Office Furniture Dealers Alliance (OFDA). And the gravity of the situation depends on several factors, he adds.
"For large dealers that do project work with long lead times, those projects will continue. In fact, these type of dealers had some very good 2007 results in terms of sales and profits. There’s no question that among the smaller end of the market, however, companies have pulled back their expenditure."
The latter, so-called transactional furniture dealers which typically deliver straight from stock and on a more ad-hoc basis, meanwhile, have started seeing some impact from late last year. Florida and parts of California in particular have been reported as areas where there has been a lot of pull-back in terms of discretionary office furniture purchases through SMEs.
For office furniture manufacturers the picture is equally mixed, says MMQB’s Editor-in-Chief Michael Wolf: "The larger manufacturers have not suffered too much so far as they’ve greatly increased their exports over the last year. Due to the weak dollar, US office furniture is comparatively cheap elsewhere. Plus, the likes of Steelcase, Herman Miller and Haworth all operate in Europe and are doing quite well there. But – similar to the reseller channel – the smaller and mid-sized operators are increasingly noticing the effect of the economy."
It’s not only a matter of size, however, but also of the type of furniture produced. The furniture business of HNI, for example, which mainly manufactures for the lower end of the market and sells through small dealers as well as the likes of Staples, Office Depot and OfficeMax, saw operating profit slump by 52 percent in the first quarter of this year, from $39.1 million last year to $18.8 million in Q1 2008. Sales, meanwhile fell by 6.4 percent to $466 million in the quarter.

 

"We faced very challenging economic conditions during the quarter," confirmed president and CEO Stan Askren, adding that "demand in the supplies-driven channel of our office furniture business, which primarily consists of SOHO purchases, experienced substantial weakness".
Rising raw material costs and energy prices are two added factors that will increasingly impact on manufacturers’ performances – and prices. Plus, if the US economy continues its weakness and once long-term contracts are fulfilled, large manufacturers too will be affected. Says Jerry Epperson, Managing Director at Mann, Armistead and Epperson, an investment firm specialising in the office furniture industry: "During the depths of an economic slowdown, few major new projects are signed because of the economic uncertainty, so the office furniture sector may be slow to recover when the economy rebounds, at least until corporate America is confident to again begin expansion.
"That said," he adds, "we have already seen an increase in office vacancy rates. As vacancies rise, the owners of these buildings tend to offer greater incentives to move into their space and that is what encourages greater corporate mobility as the economy recovers and is a big help in getting the industry back to a healthy level."
Not all doom and gloom then – at least not in the long-term.
China: A deflating balloon?
In the general debate about the current state of the economy and its impact on the OP industry, all eyes are on the US with its slowing consumer confidence and the repercussions of the sub-prime mortgage crisis.
But the global OP industry is also affected immensely by what happens in China due to rapidly growing costs in the country. Between 2002 and 2006, raw material prices in China increased by an average of 34 percent. Over the past year alone, prices are said to have gone up a further 20 percent. Rising wages and increasing pressure on Chinese companies to improve employees’ working conditions – all at a huge cost – are contributory factors to the general feeling of concern.
Add to that the plunging US dollar versus a very strong Chinese yuan and the outlook is sombre for Chinese exporters as well as international companies sourcing from China.
Historically, even sourcing in China by European companies was done in US dollars as part of the currency’s global status but, according to Jan van Belleghem, director of European wholesaling alliance interACTION, this is beginning to change as European players are pressing for the much more favourable euro-yuan conversion rate.
"For the moment, it’s still a very complex process," he says. "As a whole the state of the economy with all its variations hasn’t stemmed the level of sourcing from China."
And the alternatives are not that attractive, he adds. While Vietnam is often named as a viable sourcing destination, insufficient infrastructure and a sheer lack of available workforce (1.5 billion people live in China versus 84 million in Vietnam) counteract the positive arguments of such a shift.
So while OP interest in the country appears to be holding up, the economy as a whole is suffering. OPI has been advised by reliable sources that a range of factories in northern China have been shut down on a temporary basis to curb pollution in the run-up and during the Beijing 2008 Olympic Games in August, suggesting a knock-on effect on economic performance.
Soaring inflation in the region has also become a major concern, particularly in China following the devastation brought on by the earthquake in May.

 

China’s economic bubble is sure to incur some wobbles in the medium term.